Financial Accounting Theory

Seventh Edition

William R. Scott

Chapter 11

Earnings Management

Chapter 11

Earnings Management

I

What Is Earnings Management?

• Earnings management is the choice by a manager of

accounting policies (accruals), or real actions, that affect

earnings so as to achieve some specific reported earnings

objective

– Real actions to manage earnings include, for example, cutting or

increasing R&D and advertising; manufacturing for stock

– Accrual-based earnings management includes, for example, managing

the allowance for bad debts, changing amortization policy

>> Continued

What Is Earnings Management? (continued)

• Here, we concentrate primarily on the role of accruals in earnings

management

– Note the “iron law” of accruals reversal: if accruals increase earnings this

period, their reversal lowers earnings in future periods

• Two types of accruals

• Non-discretionary: management has little discretion to control amounts

• Discretionary: management has discretion to control amounts

• To discover role of accruals in earnings management, accountant needs to

separate these two types

• Jones model usually used for this separation

11 - 4

11.2 Patterns of Earnings Management

• Bath

• Income minimization

• Income maximization

• Income smooth

11.3 Evidence of Earnings Management for

Bonus Purposes

• A contractual motivation

– Bonus plan hypothesis: to manage cash bonus

• Evidence: [Healy (1985)]

– Confined to bonuses based on net income

– Recall concepts of bogey and cap

– Evidence of upward earnings management when net income between bogey

and cap

• Measuring discretionary accruals

– Healy used total accruals as proxy

– Now usually based on Jones model

» Continued

11.4 Other Earnings Management

Motivations

• Other contractual motivations

– To avoid violation of debt covenants

• Evidence: Dichev & Skinner (2002), text Section 8.5

– They report evidence of earnings management to maintain debt covenant ratios

well above contracted values (covenant slack)

– To avoid political costs

• Evidence: Jones (1991), text Section 11.3

– designed the Jones model to separate discretionary and non-discretionary accruals.

Reports firms used income-reducing discretionary accruals to bolster their case for

tariff protection

>> Continued

Other Earnings Management Motivations (continued)

• To meet investors’ earnings expectations

– Strong negative share price reaction if expectations not met

– Damage to manager reputation if expectations not met

• Evidence: e.g., Jackson & Liu (2010), found evidence of management of

bad debt allowances to avoid missing market’s earnings expectations

>> Continued

Other Earnings Management Motivations(continued)

• Initial public offerings

– To increase proceeds of new share issues

• Cohen & Zarowin (2010) find evidence of use of income-increasing discretionary

accruals in years of SEOs.

– They also report use of real earnings management techniques to increase reported

net income

– They report declining ROA for 3 years following SEO, driven in part by accrual reversal

• Dechow, Ge, Larson & Sloan (2011) (Section 11.6). A sample of firms charged by

SEC with financial statement misstatements were actively raising additional

capital

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11.5 The Good Side of Earnings Management

• Investor-based arguments for good earnings management

– To credibly communicate inside information to investors

• Blocked communication may inhibit direct disclosure of earnings

expectations

• Discretionary accrual management as a way to credibly reveal

management’s inside information about earnings expectations

– Manager foolish to report more earnings than is expected to persist

– So, manage reported earnings to an amount management expects will persist,

thereby revealing inside information about future profitability

>> Continued

The Good Side of Earnings Management (continued)

• Contract-based arguments

– To give firm some flexibility in the face of rigid, incomplete contracts

• Bonus contracts based on net income

– New accounting standards may lower net income and/or increase volatility.

May adversely affect manager effort

• Debt covenant contracts

– New accounting standards may increase probability of debt covenant violation

– Contract violation is costly, earnings management may be low-cost

way to work around

» Continued

The Good Side of Earnings Management (Continued)

• Theoretical models supporting good earnings management

– Demski & Sappington (1987a & b)

• To unblock inside information

» Continued

The Good Side of Earnings Management (continued)

• Empirical evidence of good earnings management– Tucker & Zarowin (2006)

• Greater use of income smoothing (their measure of accruals-based earnings management) positively associated with share returns. Suggests that investors value earnings management that smooths out non-persistent items.

– Other studies

• Bowen, Rajgopal, & Venkatachalam (2008)

• Liu, Ryan, & Whalen (1997)

• Das, Shroff, & Zhang (2009)

• Cready, Lopez & Sisneros (2012) (Section 11.6)

• Jayaraman (2008) (mixed results)

• Francis, LaFond, Olsson, & Schipper (2005) (mixed results)

Earnings Management at General Electric

• Text, problems 11.8 & 11.9

• Earnings management devices used by GE 1993-2007

– Assumed rate of return on pension funds

– Restructuring charges

– Acquisitions, sales of divisions

– Conservative accounting practices

• Sales of leased aircraft

– Allocation of goodwill on purchase of subsidiaries

• Earnings management devices used in harmony to report steadily increasing earnings

– See next slide

» Continued

Earnings Management at General Electric(continued)

• GE Reported Net Income

(Millions)

– 2008 $17, 235

– 2007 22,208

– 2006 20,700

– 2005 16,353

– 2004 16,593

– 2003 15,002

– 2002 14,118

– 2001 $13,684

– 2000 12,735

– 1999 10,717

– 1998 9,296

– 1997 8,203

– 1996 7,280

– 1995 6,573

– 1994 4,726

– 1993 4,315» Continued

Earnings Management at General Electric(continued)

• Note argument that even under securities market efficiency,

GE is so large and complex that even analysts cannot prepare

accurate earnings forecasts

– Management has best inside information about expected persistent

earnings

– Direct communication blocked

– Creates role for earnings management to reveal management’s

expected persistent earnings

• Is this good or bad (i.e., opportunistic) earnings management?

Earnings Management at General Electric(continued)

• Theory in Practice 11.2

– GE reports lower earnings for quarter ended March 31, 2008

– Share price falls by 13%

– Why did share price fall?

11.6 The Bad Side of Earnings Management

• Contracting Perspective

– Healy (1985) (Section 11.3, Slide 11.6)

• Reports evidence of management use of accruals to maximize their cash

bonuses

• Is this good or bad earnings management?

» Continued

The Bad Side of Earnings Management (continued)

• Financial Reporting Perspective

– Hanna (1999)

• Investors and analysts look to core earnings, ignoring provisions for

extraordinary and non-recurring items

• Implies manager not penalized for non-core provisions, such as

writedowns, provisions for restructuring

• But current non-core provisions increase core earnings in future years,

through lower amortization and absorption of future costs

» Continued

The Bad Side of Earnings Management (continued)

– Hanna (continued)

• As a result, managers tempted to “overdose” on non-core provisions, thereby putting earnings “in the bank”

– also called cookie jar accounting

– Note securities market reaction

• Elliott & Hanna (1996) found evidence that investors use frequency of such provisions as proxy for their misuse—they found lower ERC when greater frequency

• Would full disclosure in income statement of effect on net income of past writedowns provide useful information to investors?

>> Continued

The Bad Side of Earnings Management (continued)

• More recent studies of bad earnings management

• Leuz, Nanda & Wysocki (2003)

• Countries with poor investor protection experience more earnings

management

• McInnis & Collins (2011)

• Increase in accrual quality (i.e., less bad earnings management)

following availability of cash flow forecasts

>> Continued

11 - 21

The Bad Side of Earnings Management (continued)

• Recent examples of bad earnings management• Groupon Inc., Theory in Practice 11.1

• Extreme income maximization

• Capitalize marketing costs

• Emphasize pro-forma income

• Olympus Corp., Theory in Practice 11.3

• Elaborate scheme to avoid huge writedown of investments, by

transferring loss to purchased goodwill

>> Continued

11 - 22

The Bad Side of Earnings Management (continued)

• Standard setters response to bad earnings management

– IAS 37

• Before recording a provision, payments must be probable and capable of

reliable estimation

• Provision must be valued at fair value

• No excess provision as a result of uncertainty

• Provisions must be used only to absorb costs for which provision originally

set up

– ASC 420-10-25

• No provision until liability incurred

– Do these solve problem of abuse of provisions?

• Management controls timing

• Fair values require estimation>> Continued

The Bad Side of Earnings Management (continued)

• Do managers accept securities market efficiency?

– Perhaps

• Poor disclosure enables earnings management even if markets are

efficient

– Perhaps not

• Theory and evidence that securities markets may not be fully efficient

supports a “no” answer

• Evidence that efficiency not accepted

– Pro-forma earnings» Doyle, Lundholm, & Soliman (2003), Heflin & Hsu (2008)

– Managing same-quarter earnings of previous year» Schrand and Walther (2000)

>> Continued

The Bad Side of Earnings Management (continued)

• Analyzing Managers’ Speech to Detect Bad Earnings Management

• Cognitive dissonance

• Arises when persons behave contrary to their opinion of themselves—e.g., a

misleading statement produces a guilty feeling

• An individual will react by trying to reduce his/her dissonance

• Will try to change his/her beliefs

• Will back off somewhat from the dissonance-creating statement

• Sophisticated computer programs can detect these reactions

• Hobson, Mayhew & Venkatachalam (2012)

• Analyzed managers’ speech during earnings announcements, obtaining a cognitive

dissonance score for each manager

• Found that higher dissonance score associated with future earnings revisions

11 - 25

11 - 26

Earnings Management at Sunbeam Corp.

• See Problem 11.10 text

• Devices used by Sunbeam to manage earnings upwards

– See next slide

• Note loss reported 1st Q. 1998

– Illustrates “iron law” of accrual reversal

• Where was auditor?

>> Continued

11 - 27

Earnings Management at Sunbeam Corp.

The Bad Side of Earnings Management (continued)

• Can accountants reduce bad earnings management?

– Yes, if full disclosure of

• Revenue recognition policies

• Unusual, non-recurring and extraordinary events

– Enables investors to better evaluate earnings persistence

• Effect of previous writeoffs on current core earnings

– Hanna ( 1999)

11.7 Conclusions

• Earnings management can be good if used responsibly

• Full disclosure helps to control bad earnings management